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Brookings Panel Points To “Grand Bargain” – Carbon Tax to Reduce GHG Pollution and Deficit

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Last Wednesday, the Brookings Institution hosted “America’s Energy Future: New Solutions to Fuel Economic Growth and Prosperity.” The first panel, “New Policies for a Cleaner Economy,” featured heavy-hitters: John Deutch (MIT “Institute” professor, former CIA Director…), Joseph Aldy (former Obama assistant on climate & energy), as well as Brookings Senior Fellows Ted Gayer and Michael Greenstone, who moderated.

Greenstone opened by noting how closely-linked energy consumption is to our well-being, but strongly cautioned about very serious un-priced side effects, especially from fossil fuels. Gayer recommended reforming government cost-benefit analysis to focus more on those un-priced externalities, especially since consumer benefits, he noted, are already efficiently priced into markets. Deutch advocated creation of a national energy technology research corporation to harness private sector investment free of a Department of Energy that “is mostly about bombs.” Aldy proposed a technology-neutral “National Clean Electricity Standard” to tax carbon-intense electricity generation and credit low- and zero-carbon electricity,  while providing federal revenue.

Greenstone asked the panel if their proposals wouldn’t be better replaced by a “grand bargain” to provide more of what we like: income, and less of what we dislike: carbon pollution. “[T]he giant prize standing in front of us is the realization that one could raise revenue instead of raising income taxes… through a carbon tax or some kind of carbon charge.” Aldy enthusiastically agreed, claiming “evidence of bipartisan support” and pointing out that he and Brookings economist Adele Morris proposed a carbon tax to the Obama deficit commission.

Deutch chimed in, “I couldn’t agree more with a proposal to do a comprehensive greenhouse gas tax. It depends, of course, on how it’s designed… and how you allocate the revenue. So if you put onto a tax proposal like you say a revenue proposal, then you have at least some chance of selling it.” Deutch urged return of some revenue to taxpayers as “walking around money.” “We’ve got to get the legislation passed,” he concluded.

What’s the matter with elasticities? (Answer: maybe nothing)

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(This piece was originally posted to Grist on April 29, 2011.)

Price-elasticities — dimensionless parameters that express the extent to which a price increase triggers a usage decrease — are central to policies that aim to reduce a harmful activity by internalizing its damage into its price. The efficacy of carbon fees, congestion tolls, cigarette taxes, and the like turns on the proposition that the toll or tax will dampen consumption by more than a token amount.

If the price-elasticity is close to zero, then the fee devolves to a revenue-raiser that will never fulfill the purpose of reducing the harm. But if there’s at least a modicum of underlying price-responsiveness, then internalizing damage costs via a fee or tax can be a powerful and efficient way of combating pollution, while also raising revenue that can be invested and/or distributed to forestall regressive impacts on lower-income households.

As someone with a long-time orientation toward price incentives and cost internalization, particularly for major sources of environmental damage such as energy use and driving, I’ve made it my business to keep on top of the literature on price-elasticity. Several years ago, in the course of assembling a monster spreadsheet for modeling congestion pricing in New York City, I spent months combing empirical studies of driver responsiveness to changes in tolls, gas prices, and parking charges. Ditto to develop the Carbon Tax Center’s carbon-tax impact model, which subdivides energy use into four sectors — electricity, gasoline, aviation, and “other” — with different estimates of price-elasticity for each.

With this backdrop, consider the strange post this week by The Atlantic business and economics editor Megan McArdle.

McArdle’s piece, “Should We Re-Evaluate Carbon Taxes?,” began well enough:

I’ve long been an advocate of some form of carbon taxation — gas tax, source fuels tax, even cap-and-trade if nothing else is available. The tax seems like a three-fer: raise revenue, discourage use, and encourage innovation.

McArdle has indeed been a staunch carbon tax advocate. Back in 2007, in “The perils of buy local,” she noted the absurdity of making individuals track the carbon footprints of local vs. global food, and concluded:

[I]f we’re serious about cutting carbon dioxide emissions, we need a carbon tax, and not CAFE, or other sorts of piecemeal regulatory solutions.

While I wouldn’t have cast it as either/or, McArdle’s emphasis on a carbon tax is exactly right.

But McArdle’s new piece quickly leaves the rails:

Jim Manzi has been making a pretty compelling argument that [a carbon] tax will do much less than people like me have been anticipating. Even the long-term response to price increases is simply too low.

This is weird. For Manzi’s “compelling argument” turns out to be nothing of the sort. Rather than a considered examination of the vast body of studies of energy elasticities, Manzi’s “argument” is a lone table cherry-picked from the International Monetary Fund’s (IMF) new (April 2011) 242-page World Economic Outlook [PDF]. And lifted from the IMF not by Manzi himself but by Mother Jones political blogger Kevin Drum, in a post last Friday, “Everyone Loves Oil,” which in turn was built around a post the same day by peak-oil blogger Stuart Staniford.

OK, no crime in linking to someone else who linked to someone else who linked to someone else. For the goods, let’s go to the IMF table posted by Staniford, Drum, Manzi, and McArdle:

Chart.

Hmm, looks like an elasticity-killer — on a quick glance. Over the period 1990-2009, the long-term price elasticity of oil demand shown for OECD countries — developed nations like the U.S., Western Europe, and Japan — is a meager 0.093. At that rate, a 40 percent rise in the price of oil would drop consumption by only 3 percent — a paltry impact, and far too small to justify putting a carbon tax at the center of climate policy.

But wait. The actual change in U.S. gasoline consumption over the past two decades tells quite a different story:

  • From 1990 to 2010, the real pump price rose 40 percent (I’ve removed general inflation of 67 percent from the 133 percent nominal price rise from $1.22 to $2.84 per gallon; elasticities are calculated on real, not nominal, price changes).
  • U.S. gasoline consumption grew by 25 percent over this period, from 7,235,000 to 9,034,000 million barrels a day.
  • Real GDP grew by 65 percent.
  • Let’s assume that, all things equal, each percent increase in economic activity is accompanied by a half-percent increase in gasoline use (i.e., an income-elasticity of 0.5). This mid-range assumption is more conservative than the 0.67 income-elasticity I’ve assumed for years.

With these inputs, the observed price-elasticity of U.S. gasoline demand over the past 20 years is around 0.20. The simplest way to see this is to observe that, absent price effects, the increase in gasoline usage would have been half of the GDP rise of 65 percent, or 32.5 percent. The actual increase, however, was 25 percent. Dividing the demand “shortfall” of 7.5 percent by the 40 percent real price increase yields an elasticity of around 0.20. (The true elasticity derived from these numbers is (negative) 0.23, since that’s the exponent to which 1.4, the price multiple, must be raised to yield 0.925, the quantity multiple (1 minus 7.5 percent).) That’s twice the long-term elasticity for OECD countries in the IMF table that McArdle et al. relied on.

But this correction to a 0.20 gasoline price-elasticity estimate is just for starters. As everyone knows, the long-term rise in gasoline prices has been more fluctuating than monotonic. Over the past eight years, the month-to-month price has fallen 43 percent of the time [see the “Volatility Graph” tab in this spreadsheet], obscuring the overall upward trend and giving drivers, car-makers and regulators alike a recurring “out” from the task of adapting to higher prices. Thus, the rough gasoline price-elasticity figure of 0.20 almost certainly understates the reductions in gasoline demand that a ramped-up, phased-in carbon tax, with its unambiguous price signal, could deliver.

To its credit, the IMF acknowledges this, in its Technical Appendix that McArdle et al. evidently overlooked:

To examine whether high oil prices are more conducive to substitution away from oil than low oil prices, we split the sample into periods of high and low oil prices … The results (Table 3.4) suggest that during periods of low oil prices, price elasticity is not statistically different from zero … In contrast, during periods of high oil prices, price elasticity is much higher, at 0.38. [p. 132/242. Note also that the figure of (negative) 0.038 in Table 3.4 is a typo; according to an IMF staffer I contacted, the intended figure, matching the text, is 0.38.]

As it happens, 0.38 roughly matches the 0.40 price-elasticity figure I inputted into my carbon-tax impact model. It’s also essentially the estimate of the long-run U.S. gasoline price-elasticity that the Congressional Budget Office proffered in its 2008 report, “Effects of Gasoline Prices on Driving Behavior and Vehicle Markets” [PDF]:

Estimates of the long-run elasticity of demand for gasoline indicate that a sustained increase of 10 percent in price eventually would reduce gasoline consumption by about 4 percent. That effect is as much as seven times larger than the estimated short-run response, but it would not be fully realized unless prices remained high long enough for the entire stock of passenger vehicles to be replaced by new vehicles purchased under the effect of higher gasoline prices-or about 15 years. Over that time, consumers also might adjust to higher gasoline prices by moving or by changing jobs to reduce their commutes-actions they might take if the savings in transportation costs were sufficiently compelling. Those long-term effects would be in addition to consumption savings from short-run behavioral adjustments attributable to higher fuel prices. (p. XI)

It’s also helpful to keep in mind that gasoline is both a minority factor in CO2 emissions (21-22 percent of the U.S. total) and the least-elastic large consuming sector. Gasoline demand is considered less price-sensitive than aviation, for which fuel accounts for a larger fraction of the overall cost than it does for driving; less price-sensitive than electricity, for which efficiency upgrades and behavioral changes provide rich opportunities for conservation; and probably less price-sensitive than home heating, manufacturing, trucking, etc., which my model subsumes under the rubric of “other.” The model assumes price-elasticities of (negative) 0.70 for electricity, 0.60 for aviation, and 0.50 for other, along with 0.40 for gasoline.

To see what these numbers mean, let’s select the (negative) 0.50 elasticity for “other”: A carbon tax that raised the price of heating oil, manufacturing fuels, etc. by 50 percent would be expected to reduce usage by 18-19 percent, since the assumed price multiple of 1.5 (that’s 1 + 50 percent) raised to the negative 0.50 power (that’s the elasticity) is 0.816, which is one minus 18.4 percent. As the carbon tax kept kicking in, a doubled price would reduce usage by nearly 30 percent, since 2 (reflecting the doubled price) to the negative 0.50 power is 0.707. Now we’re getting somewhere.

So McArdle, take heart. And Manzi, Drum, and Staniford, take note: There’s nothing wrong with price-elasticities, and little that a robust carbon tax couldn’t do, in conjunction with smart policies to remove institutional barriers to efficiency and renewable. Stop kvetching, and get on board.

Postscript: As I was posting this piece, my Carbon Tax Center colleague James Handley directed me to an April 27 post by Adam Ozimek, “Of carbon taxes and price elasticities“, that makes many of the points offered here … and more elegantly.

GAO: Offsets Loom as Gaping Hole in Cap-and-Trade’s “Containment Vessel”

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Offset quality. Hardly as riveting as nuclear meltdown, but if “complex,” “unmanageable” and “unwarranted assumptions” are themes of the month, the Government Accountability Office’s new report, “Options for Addressing Challenges to Carbon Offset Quality” carries the tune that’s in the air.

The GAO report, compiled at the request of Rep. Darrell Issa (R-CA), House Committee on Oversight and Government Reform chair, updates GAO’s 2008 “Lessons Learned” report on the European Union’s Emissions Trading System. The ETS relies on offsets from two UN programs, the “Clean Development Mechanism” (CDM) and Reducing Emissions from Deforestation and Forest Degradation (REDD). GAO’s 2008 report found that the EU ETS had “established” a market for CO2 emissions but noted that over-allocation of allowances in excess of demand had resulted in “a price collapse.” GAO concluded that Phase I of the ETS had “uncertain” effects on emissions in the capped countries while funding offsets of doubtful value, but held out hope that reforms could make the system work.

Offsets were a cornerstone of the Waxman-Markey cap-and-trade bill that passed the House in 2009 and of the ever-changing but never-publicly-disclosed proposals that Senator Kerry floated in the Senate last year. They have been touted as “cost control” measures to moderate rises in energy prices that would result from steadily reducing the cap in CO2 emission permits. Their allure lies in their apparent capacity to slip out of one of the iron laws of economics—that a constraint in supply (in this instance, via the emissions “cap”) requires a commensurate rise in price.

Offsets attempt to take advantage of (and fund) low-cost greenhouse gas emissions reductions or sequestration projects, particularly in developing countries, as an alternative to more costly reductions in the capped industry or country. The new GAO report documented three serious problems with offsets: additionality, measurement and verification. And GAO also raised questions about the permanence of sequestration projects like forests that can later be burned as fuel, relinquishing the climate benefits that were bought with offset credits.

Additionality is the problem of answering a hypothetical question. What would have happened if offsets hadn’t funded this project? GAO found many projects that have gotten a boost from offsets, but with no clear sense as to whether they would have been built anyway without the incentive of offset credit. What is the baseline? It’s an un-testable assumption. GAO found that it’s been a challenge for the UN and EU ETS to even write rules about how to review projects (which vary widely in concept, location, quality and cost) while the offset “industry” and large purveyors of offsets, particularly China, are clamoring for ever more streamlined UN approvals.

Measurement is a complex accounting problem—how much CO2 was avoided by this project or process or by preserving this forest? While global accounting firms assure us that they can provide systematic measurement and reliable figures, GAO found that measurement is neither consistent nor transparent, despite a decade of effort by the UN.

And verification – who’s checking on completion, operation and maintenance of these projects? Unsurprisingly, GAO reported that, “Project developers and offset buyers may have few incentives to report information accurately or to investigate offset quality.” Everyone in the offset business – from project developers to offset sellers and buyers ─ wants offset values set as high as possible. There’s a worrisome parallel to the 2008 financial collapse: the bubble in mortgage-backed securities arose in part because slicing and bundling mortgages into securities (and derivatives) made it impossible to identify and assess the value of a particular property whose value is securing the loan. Offsets start out as intangibles; everyone in the system is rewarded for over-stating their value. GAO argues that strong, independent oversight is needed, but its report raises serious doubts about whether oversight, which is administratively expensive to boot, can ever be sufficient.

Perhaps most tellingly, the new GAO report confirms the worst fears of offset critics ─ that the global offset system places new hurdles in the path of energy-efficiency and other decarbonizing measures, in the form of perverse incentives under the Clean Development Mechanism [CDM] program:

[A]n offset program may create disincentives for policies that reduce emissions. For example, under an offset program that allows international projects, U.S. firms might pay for energy efficiency upgrades to coal-fired power plants in other nations. According to our previous work [GAO’s 2008 report on the EU ETS], this may create disincentives for these nations to implement their own energy efficiency standards or similar policies, since doing so would cut off the revenue stream created by the offset program.

For example, some wind and hydroelectric power projects established in China were reviewed and subsequently rejected by the CDM’s administrative board amid concerns that China intentionally lowered its wind power subsidies so that these projects would qualify for CDM funding. In addition, our review of the literature suggests that in some cases an offset program may unintentionally provide incentives for firms to maintain or increase emissions so that they may later generate offsets by decreasing them. This potential problem is illustrated by the CDM’s experience with industrial gas projects involving the waste gas HFC-23, a byproduct of refrigerant production. Because destroying HFC-23 can be worth several times the value of the refrigerant, plants may have had an incentive to increase or maintain production in order to earn offsets for destroying the resulting emissions.

The HFC-23 offsets cited by GAO are perhaps the most egregious example of the perverse behavior that offsets induce. Credits for the destruction of HFC-23 represented 59% of the offset value traded in the UN’s CDM in 2009. HFC-23 is an unwanted by-product of the chemical reaction that produces the refrigerant, HCFC-22. Because its greenhouse gas potential per pound is 11,700 times that of CO2, destroying even a few pounds of HFC-23 earns vast offset credits even though the destruction process is not particularly costly or difficult.

Stanford University Professor Michael Wara calculated that whereas installing equipment to capture and destroy HFC-23 at all of the facilities covered by CDM would cost $100 million, these same projects are expected to generate $4.7 billion in CDM offset credits by 2012. Not surprisingly, the availability of huge sums in the offset market creates incentives for construction of HCFC manufacturing facilities beyond demand for the refrigerant, as well as incentives for developing countries to avoid mandating the installation of emission control equipment, all so that the “baseline” for project evaluation remains uncontrolled release. Enactment of a law requiring control equipment would raise the baseline and thus eliminate the potential for HFC-23 offset credit. You can bet China won’t be enacting that law so long as CDM allows credit for destroying HFC-23.

CDM projects must be approved for offset credit.  The process for approval of livestock methane capture projects illustrates the steps that GAO found that such projects generally have to follow:

(1) conduct either an investment analysis to show that methane capture was not attractive without revenue from the sale of offsets, or demonstrate that offsets allow the project to overcome some prohibitive barriers;

(2) demonstrate that methane capture is not already common practice in that area; and

(3) define an appropriate baseline from which offsets would be awarded.

The GAO report weighed the trade-offs in terms of accuracy, administrative cost and flexibility against the increased approval speed that might be available from a standardized approval process. Acknowledging that even the best oversight and management can’t assure high offset quality, GAO suggests limiting the fraction of CO2 reductions that offsets would be permitted to provide under national cap-and-trade programs.

[T]he emissions reduction program would ensure that only a fixed percentage of the emissions permits could be affected by any problems with offset quality. All existing emissions reduction programs we reviewed use this option. In the EU ETS, regulated entities are able to use CDM credits for 12 percent of their emissions cap, on average, through 2012. In contrast, a draft Senate bill [the “American Power Act”] would have allowed a greater number of offsets into the program—approximately 42 percent of the emissions cap during the first year of the program. These percentages are based on the total emissions cap, not the required emissions reduction. As a result, such limits could mean that regulated entities could use offsets for all of their required emissions reductions, assuming a sufficient supply of offsets was available.

In other words, GAO concludes that in the Senate’s failed cap-and-trade bill, offsets could have completely overwhelmed the cap (which only declines a few percentage points each year) for decades. That’s exactly what International Rivers and Prof. Wara predicted just days before Waxman-Markey passed the House (219-212) in June 2009.

To limit the problems with offsets, GAO suggests only allowing certain types of offset projects or discounting their value so that only a fixed fraction of the avoided emissions are counted, perhaps tailoring the fraction to the type of offset project. Disappointingly, GAO stops short of suggesting complete elimination of offsets so that emitters would face a real cap that would induce a real carbon price. And, of course, that would point to a much simpler, direct way to set a stable and predictable price: a gradually-rising carbon tax.

Former Fed Vice-Chair Urges — Show The CO2 Price Now! (Two Years Ahead of Time)

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Everyone from the President on down professes to want more hi-tech jobs and cleaner energy. Here’s a prescription for getting them: enact a gradually-rising carbon tax but delay its implementation for two years to avoid dampening the fragile economic recovery.

That’s former Fed Vice-chair and Princeton Econ. professor Alan Blinder’s message in “The Carbon Tax Miracle Cure,” broadcast today from the pulpit of free-market orthodoxy, the editorial page of the Wall Street Journal:

[A] carbon tax… should be enacted now [but] set at zero for 2011 and 2012. After that, it would ramp up gradually… What’s critical is that we lock in higher future costs of carbon today.

Once America’s entrepreneurs and corporate executives see lucrative opportunities from carbon-saving devices and technologies, they will start investing right away—and in ways that make the most economic sense… I can hardly wait to witness the outpouring of ideas it would unleash. The next Steve Jobs, Bill Gates and Mark Zuckerberg are waiting in the wings to make themselves rich by helping the environment.  Jobs follow investment, and we need jobs now.

Blinder recommends using carbon tax revenue to reduce the deficit and underscores the advantages of a carbon tax over other deficit reduction strategies:

[E]very realistic observer knows that closing our humongous federal budget deficit will require a mix of higher taxes and lower spending as shares of GDP. Forget about value-added taxes and other new levies you may have heard about. A CO2 tax trumps them all… reducing our trade deficit, making our economy more efficient, ameliorating global warming, and showing the world that American capitalism has not lost its edge.

Now that “hiding the price” behind cap-and-trade has crashed politically, Prof. Blinder is urging Congress to try the opposite: show the price—two years ahead of time—and let the expectation of a rising price on CO2 pollution do its job-creation and climate work. As for the politics, Blinder drags out the familiar Churchill quote: “You can always count on Americans to do the right thing—after they’ve tried everything else.” It’s a cliché, all right, but it might just apply.

Add OPEC Profiteering to List of Reasons to Ditch Cap-and-Trade

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The drawbacks of the cap-and-trade approach for pricing and reducing carbon emissions are legion. They include complexity, volatility, lack of price predictability, vulnerability to financial speculation, and impossibility of harmonizing across borders.  Now there’s another, courtesy of a 2010 report by an economist at the World Bank: Institution of a cap-based emissions program by oil-importing countries works to increase oil exporters’ market power, revenue and profits; whereas a carbon tax would have the opposite effect.

That’s the conclusion we draw from Jon Strand’s “Taxes and Caps as Climate Policy Instruments with Domestic and Imported Fuels.” As Dr. Strand, who chairs the economics department at the University of Oslo and has served as a senior economist at the World Bank since 2008, wrote:

[A] c-a-t [cap-and-trade] solution … leaves [oil importing countries] more vulnerable to adverse strategic manipulation of fuel prices by monopolistic exporters.[ [Conversely,] a tax is more efficient than a cap at extracting rent from fuel (oil) exporters. [Abstract and p. 32]

For his paper, Strand modeled a simple situation: Region A consumes two classes of fuels: imported oil and domestically-produced energy. Region B (interpreted as OPEC, plus Russia) exports fuel (oil) to Region A. Each region seeks to maximize revenue in response to the strategy of the other region. Strand concluded that the consuming region would be strategically weaker vis-à-vis the producing region under a carbon emissions cap than under an equivalent carbon tax.

Here’s why: Micro-economic theory teaches that a monopolist sets an optimum price to maximize revenue. Set the price too high, and sales volume falls, more than offsetting the increased revenue generated by a higher price. Set the price too low, and increased sales don’t overcome the lost revenue. Now picture a carbon emissions cap legislated by the importer, Region A. Because the cap constrains sales volume, the monopolist exporter can shift its (optimal) price upward without cutting sales volume. In contrast, were the importer to implement a carbon tax, this would reduce the exporter’s optimal (revenue-maximizing), price because the higher, tax-including price would reduce sales.

As Strand puts it, under cap-and-trade,

[T]he exporter strategically adjusts its tax [or export price] so as to extract maximum rent from the importer, at the given (exogenous) cap, leading to a zero equilibrium value for tradeable emissions quotas in the importer region.

Strand’s analysis points to a fundamental issue that cap-and-trade promoters tend to play down. A cap is an indirect way to set a price by limiting supply. But if someone upstream — the fuel exporter or its government — raises the price (or tax), the allowance price will fall. In the extreme, the exporter could raise the price enough to achieve the emissions reductions mandated by a cap and drive the allowance price down to zero. In other words, the importing nation’s cap enables the fuel exporter to reap a windfall by raising prices without sacrificing sales because falling allowance prices under the cap will tend to “absorb” the exporter’s price increase. In contrast, with a fixed (or gradually-rising) carbon tax, the exporter will be pressed to reduce prices to compensate for the tax in order to maintain sales volume at the revenue-maximizing point.

Strand isn’t the first economist to suggest this advantage of a carbon tax. In 2009, economists at the University of Ontario concluded that in addition to reducing CO2 pollution and providing revenue with which to reduce other taxes, carbon taxes offer a third important benefit: transferring revenue from OPEC to oil-importing countries, reducing OPEC’s monopoly power. Similarly, in an earlier (2002) paper, “Can Carbon Tax Eat Opec’s Rents?,” economists from MIT and the Helsinki School of Economics concluded that a “carbon tax can be used to reduce the producer price of fossil fuels and thereby to shift resource rents from the resource-exporting countries.”

The European Union’s cap-and-trade experience during the current steep recession offers insight into caps’ perverse interaction with “exogenous” (outside) forces. The recession curbed economic activity, and at the same time oil prices rose. In response, energy demand fell, driving down the price of CO2 allowances needed to burn fossil fuels. The EU’s emissions have declined during recent years, not because the cap is doing much to constrain emissions, but because those exogenous factors have reduced demand. Indeed, in the “uncapped” U.S., the trend of falling emissions very closely matches the downward emissions trend in the EU. In effect, a slow economy cut demand, and higher exporter oil prices captured “rent” from under the cap, holding allowance prices down and making it less effective at “putting a price on CO2” that would induce long term investment in alternative energy.

As we learned last week from a diplomatic cable written by U.S. Secretary of State Hillary Clinton, released by Wikileaks, “[D]onors in Saudi Arabia constitute the most significant source of funding to Sunni terrorist groups worldwide.” (NYT, Dec. 5.) Saudi Arabia, of course, is the world’s largest petroleum exporter and the second largest crude oil producer (after Russia). The Saudi economy is utterly dependent on oil and petroleum-related industries, including petrochemicals and petroleum refining, with oil export revenues accounting for 90 percent of total Saudi state revenues and more than 40 percent of the country’s GDP.

It thus may not be much of a stretch to ask if a U.S. carbon cap (especially when added to an EU cap) could wind up helping funnel money to Islamic fundamentalists with terrorist inclinations. Obviously, Strand’s analysis oversimplifies the situation — oil exporters are not a strict monopoly, they do compete somewhat, and energy technology or consumption patterns could change the dynamic. But it’s worth noting that economic analysis suggests that a carbon tax would tend to work against the interests of the oil cartel, while cap-and-trade would tend to reinforce the cartel’s price-setting leverage.

Photos: Flickr–foreclosurepro, digitaltrends.

P.S. This Just In:

Ecuador Asks OPEC to Support Oil Tax on Importers (Bloomberg, 12/11/10).

“With the first global tax on carbon emissions OPEC would achieve the most efficient and just way to do what Kyoto has failed to: make carbon emitters internalize the effects of their actions and pay for the pollution they create,” Ecuador’s President Rafael Correa said.    

Should Carbon Pricing Advocates Support the Cap-and-Dividend Bill?

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Last month’s Pricing Carbon Conference at Wesleyan U. featured a debate over three competing approaches for pricing carbon emissions, each of which is embodied in bills introduced in the 111th Congress:

The Conference also offered a workshop comparing two ways to return revenues raised by a carbon tax or by selling carbon emission permits:

  • a regular “dividend” or “green check” sent to all U.S. households; vs.
  • a series of periodic reductions in payroll taxes.

Cap-and-Dividend proponent Peter Barnes, flanked by NRDC's Dan Lashof (left) and Carbon Tax Center's Charles Komanoff (right), at the Wesleyan Pricing Carbon conference.

As hoped, the Conference has sparked a flurry of substantive and strategic discussions. For example, cap-and-dividend advocate Peter Barnes is imploring us to align the Carbon Tax Center with the CLEAR cap-and-dividend bill introduced in December 2009 by Senators Cantwell (D-WA) and Collins (R-ME).

The CLEAR bill is backed by a coalition of largely grassroots organizations, who view it as a way to achieve a guaranteed reduction in emissions without the political compromises and anti-consumer aspect of cap-and-trade with offsets. We hold Peter and his coalition partners in high regard. Their cap-and-dividend concept is certainly a quantum improvement over the cap/trade/offset model that some of the mainstream environmental groups rode to defeat (again) in 2009-2010. Yet both the concept and the particulars of the CLEAR bill fall far short of what we at CTC believe is required in carbon-pricing legislation.

In this post, we contrast the CLEAR bill with the approach taken by Rep. Larson (D-CT) and 12 co-sponsors in their carbon tax bill, America’s Energy Security Trust Fund Act, which Mr. Larson pledged at Wesleyan to re-introduce in the new Congress that convenes in January.

The CLEAR Bill at a Glance

Like all cap-based bills, the CLEAR bill relies on a declining “cap” in the number of carbon emission permits to be auctioned to emitters. In CLEAR’s case, the promised decline (relative to 2005 emissions) would be 20% in 2020, 30% in 2025, and so forth, finally reaching an 83% drop by 2050. CLEAR would return 75% of the revenues from the permit auctions to all U.S. residents, with each getting an identical amount. The remaining 25% of revenue would be placed in a “Clean Energy Reinvestment Trust Fund” (CERT) for appropriation by Congress, ostensibly to “green energy” investments, mitigation, adaptation and transition assistance.

As a brake on price volatility, and to provide a modicum of price predictability, CLEAR sets a floor and ceiling on the prices of the carbon emission permits: the floor is set at $7 per ton of CO2 rising at 6.5% annually plus the rate of general inflation, with the ceiling at $21/ton, rising at 5.5% plus inflation. The floor is intended to protect investments in low-carbon measures by ensuring that fossil fuel prices include at least a minimum charge for their carbon emissions, while the ceiling is intended to shield consumers from too-rapid price rises. When the ceiling is hit, a “safety valve” in the CLEAR bill triggers auctions of additional permits at the ceiling price; the revenue from these supplemental permits is added to the CERT fund.

CLEAR’s Biggest Problem: Its Cap Hides a Much-Too-Low Price

The Carbon Tax Center has modeled the price levels needed to achieve particular emissions reductions. Our conclusion, using historical energy price-elasticity data, is stark: the CLEAR bill’s emissions reductions targets cannot be achieved within the bill’s low price ceiling. When we conveyed this finding at a meeting with Sen. Cantwell’s staff in early 2010, the response was even more stark: “We don’t intend to use (CO2) prices to reduce emissions.” — a statement that appears to deny the fundamental role of prices in driving changes in behavior.

The apparent disconnect between CLEAR’s emission targets and its price ceiling means that the ceiling price would be hit frequently, perhaps even continuously. This in turn would open the safety valve and cause the auctioning of supplemental emission permits, whose revenue would fund CERT. In effect, then, as the cap tightened, CLEAR would function like a low carbon tax (with the level set at the safety valve auction price), an increasing share of whose revenues would flow to the CERT fund. The initial promise of returning 75% of revenue would recede as the cap tightened and an increasing share of revenue went to the CERT fund. In this respect, CLEAR might even come to resemble the “Breakthrough” proposal for a low carbon tax to fund RD&D, albeit with less specificity about which technologies Congress might choose to subsidize and less clarity about the expected CO2 prices.

The CERT Fund—Big Dogs Eat First, But Can They Reduce Emissions?

Needless to say, the same interests that wrote themselves free allowances under the Waxman bill would use their political muscle to divide up the CLEAR bill’s CERT fund. Thus, no one should be surprised if “clean coal,” ethanol and other “incumbent” energy interests garnered a lion’s share of the CERT fund’s supposed “clean energy investments.”

Nevertheless, CLEAR proponents appear to assume that the CERT fund would achieve near-miraculous reductions in carbon emissions. Our modeling indicates that because CLEAR’s price level is held so low, the bill would have to rely on the CERT fund to achieve more than half of its mandated 2009-2020 emissions reductions. Indeed, with its low (5.5%) annual increase rate, CLEAR’s $21 ceiling price would rise to only about $35 in a decade; that’s less than a third of the 2020 price in the Larson bill. No wonder Larson is projected to reduce emissions by 30% by harnessing the power of real price signals, whereas the CLEAR bill would have to rely on unspecified (and likely pork-laden) energy “investment” simply to achieve a reduction of 20%.

The Vast Costs of Hiding the Price

The main (political) appeal of a cap seems to be to hide the price. Yet hiding the price from investors and households guarantees that caps will be far less effective than direct pricing mechanisms at inducing investment in low-carbon energy and efficiency. The Brattle Group, a well-respected economics consultancy, studied the price volatility in the European Union’s Emissions Trading Scheme and concluded, first, that the noisy, hidden price signal there delayed investment in alternative energy by a decade; and, second, that the cap-derived CO2 price would have to rise roughly twice as high to get the same emissions reductions as an explicit tax.

Moreover, as we saw in the acrimonious and puerile debate over the Waxman bill, “hide the price” leaves everybody with an Internet link free to speculate on the cost of the legislation, with estimates ranging from astronomical (by those opposing action) to microscopic (by those claiming that “cost controls” such as offsets would avoid the need for significant CO2 prices). The result of “hide the price” in 2009-10 was a confused public and a stymied Congress. There’s no reason to expect a clearer discussion if cap systems continue to be the preferred way to price carbon emissions.

Hiding the price under a cap also complicates international harmonization. As we described in a post here in March 2009, and “Report from Copenhagen: Forget carbon targets, just set a price” an explicit carbon tax with border tax adjustments can be an effective incentive for other nations to enact their own carbon taxes to garner the tax revenue that their carbon-taxing trading partners will otherwise collect on imports at the border.

CLEAR’s Flimsy Wall Around Wall Street

The CLEAR bill seeks to avoid inducing speculative secondary markets by fiat: prohibiting entities that buy or sell emission permits from buying and selling carbon derivatives. It also would require CFTC, FERC and FTC to promulgate regulations on CO2 emissions trading. But as the Congressional Budget Office, Robert Shapiro and other economists have concluded: because of the energy industry’s need for insurance against wild price swings, the use of hedging instruments is unavoidable in the large and volatile CO2 markets that are inherent when setting a price indirectly using a cap. It appears inevitable that a secondary market would emerge overseas, if not illicitly onshore.

CLEAR’s Big Contribution: Revenue Return

The CLEAR bill did perform a great service by bringing revenue return via “dividends” into public discussion, at a time when Waxman-Markey proposed what amounted to a 40-year earmark of carbon revenues. (W-M would have allocated 85% of allowances, overwhelmingly to “incumbent” energy interests – effectively, a hidden, volatile and regressive tax.) CLEAR would at least start with 75% revenue return, although as discussed, that fraction would diminish as the cap tightened and the price ceiling was hit. Nevertheless, revenue return via a “dividend” or “green check” offers transparency and accountability that could help build political support for carbon emissions pricing.

On the other hand, returning revenue via reduced taxes on workers, as Rep. Larson proposes, would also avoid regressivity while offering the additional advantage of employment stimulus. This kind of tax-shifting seems to be a key ingredient in the continued political and economic success of the carbon tax in British Columbia and its effectiveness has been widely recognized here, too. Cutting payroll taxes has been praised by the Congressional Budget Office as one of the most cost-effective ways to reduce unemployment. The bipartisan “Hire Now” Act, co-sponsored by Senators Hatch and Schumer, effective in March 2010, eliminated the first six months of payroll taxes on employers that hire the unemployed.

While pro rata “dividends” offer appealing transparency and simplicity, the potential for a “job-creating carbon tax” to cut payroll taxes while de-carbonizing our economy seems no less attractive, particularly with officially-measured unemployment persisting above 10%. Though we conclude that CLEAR bill is too flawed to serve as effective carbon pricing legislation, it did at least jump-start the much-needed debate about revenue return. For that, Senators Cantwell and Collins and CLEAR’s supporters deserve high praise.

Photo: Wesleyan University